Consumer confidence: does it lead or lag the economy?

When consumer confidence falls, the business community grows nervous.
But when consumers report feeling good about their own and the nation's
economic well-being, sales are expected to rise, stimulating employment
and economic growth.

A wide range of business and economic policy-makers take consumer
attitude surveys very seriously. At the beginning of 1989, the Bureau
of Economic Analysis of the U.S. Department of Commerce revised
its Index of Leading Indicators to include the Index of Consumer
Expectations, an indicator of how well-off consumers expect to be
in the future relative to today. The Data Resources Inc./McGraw
Hill (DRI) model of the macro economy uses consumer survey data
to effect decisions about housing, claiming that it indirectly affects
virtually all other sectors of the economy. The Federal Reserve
Board, which controls monetary policy, regularly considers reports
about consumer attitudes along with many other phenomena affecting
economic growth.

There is, however, considerable confusion about just what these
consumer attitude surveys really measure and what they mean for
future spending. This stems, in part, from the existence of at least
two consumer attitude surveys reported in the press that measure
slightly different things. The most commonly reported is the Consumer
Confidence Index, compiled by the Industrial Conference Board. It
measures the willingness of consumers to make major purchases in
the very near term, as does the Index of Current Economic Conditions.
The latter is one part of the also widely reported Consumer Sentiment
Index, which is compiled by the Survey Research Center of the University
of Michigan. The second part of the Consumer Sentiment Index is
the Index of Consumer Expectations, which measures how well-off
consumers personally expect to be in the future and whether they
believe national business and economic conditions will improve.

Interpreting the meaning of the Consumer Sentiment Index is complicated
because its two components indicate different spending behavior.
When consumers report that they expect to feel better off in the
future, current expenditures stagnate as consumers delay purchases
until a better time. When they feel relatively well-off today, consumers
buy now, boosting current consumer expenditures.

There are three major opinions about the usefulness of these indexes
and how they function. One, which reflects the underlying assumption
of the original surveys, suggests that consumers' attitudes and
subjective expectations respond to a variety of information and
change before buying behavior changes. Thus, consumer sentiment
can change directions independent of observable economic phenomena
and will lead changes in the economy.

The second opinion is that, at least in normal economic and political
times, consumer attitudes simply reflect economic prosperity or
adversity and therefore tend to follow observable economic trends.

A third view is that attitude data best measure the degree of
uncertainty consumers are feeling. As uncertainty increases, consumers
tend to hold their assets in more liquid forms, decreasing spending
on durable goods and creating an observable effect on aggregate
consumption and long-term investment.

Two sources of uncertainty shown to affect consumers' future expectations
are inflation and unemployment. The policy of the Federal Reserve
Board to hold down inflation should, then, be correlated with higher
consumer expectations about future well-being. But, expecting stable
prices, consumers do not rush to buy durable goods in order to beat
expected higher prices. Low inflation is a good policy for steady
economic growth, but it will not inspire consumers to jump-start
the economy.

The usefulness of these indexes of consumer attitudes in predicting
future consumer spending has been debated and researched, debunked
and praised. Most economists who have tried to incorporate these
indexes into their forecasting models have found them to add little
to what they already know from other economic data, except in times
of great uncertainty, like the 1990s.

Attitudes about current well-being seem to be more useful in predicting
consumer spending than future expectations, but forecasting models
do not seem to produce consistent results with all scenarios. For
the economic forecaster, it is a little like having a mild case
of the common cold. You can't afford to ignore it, yet it doesn't
seem to change things very much.

Over the past two or three decades these consumer attitude surveys
have gained considerable credibility. They provide a very good summary
of consumers' perception of the current state of the economy. Consumers'
confidence or uncertainty can be affected by a lot of things, such
as political news or media personalities, that are not captured
by aggregate economic data. It behooves us to watch the various
consumer attitude surveys carefully. They are one good indicator
of our economy's health.